ETFs and tax-efficiency (2024)

FAQs

Are ETFs really more tax-efficient? ›

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.

Thanks to the tax treatment of in-kind redemptions, ETFs typically record no gains at all. That means the tax hit from winning stock bets is postponed until the investor sells the ETF, a perk holders of mutual funds, hedge funds and individual brokerage accounts don't typically enjoy.

Index mutual funds & ETFs

Index funds—whether mutual funds or ETFs (exchange-traded funds)—are naturally tax-efficient for a couple of reasons: Because index funds simply replicate the holdings of an index, they don't trade in and out of securities as often as an active fund would.

As a result, both ETFs have a very low expense ratio of 0.03% and a minimum investment of $1.00. Since VTI and VOO are both ETFs, they have the same trading and liquidity, tax efficiency, and tax-loss harvesting rules.

Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.

Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.

Tax loss rules

Losses in ETFs usually are treated just like losses on stock sales, which generate capital losses. The losses are either short term or long term, depending on how long you owned the shares. If more than one year, the loss is long term.

If you hold the ETF for less than a year, you'll be taxed at the ordinary income rate.

Mutual fund investors pay capital gains tax on assets sold by their funds. ETFs​, however, don't subject investors to the same tax policies. ETF providers offer shares "in kind," with authorized participants a buffer between investors and the providers' trading-triggered tax events.

Should you hold ETFs in a taxable account? ›

ETFs can be more tax efficient compared to traditional mutual funds. Generally, holding an ETF in a taxable account will generate less tax liabilities than if you held a similarly structured mutual fund in the same account. From the perspective of the IRS, the tax treatment of ETFs and mutual funds are the same.

Capital gains from equity ETFs

However, if you have held the ETFs for longer than 1 year, the profits will be classified as long-term capital gains. These gains are exempt up to the threshold limit of Rs. 1,00,000. Any long-term capital gains over this limit are taxed at 10% (without any indexation benefits).

VTI is a total U.S. market fund and holds more than 3,500 stocks. VTI is better diversified and benefits from small and mid-cap stocks that grow into large caps. VOO is less diversified, tracking the performance of the S&P 500 Index. VOO excludes small and mid-cap stocks.

Typically, yes. ETFs are generally more tax efficient than comparable mutual funds because the “in-kind” creation and redemption feature of ETFs is designed to reduce cash transactions and capital gains distributions.

In the past year, VOO returned a total of 27.10%, which is slightly higher than VTI's 25.53% return. Over the past 10 years, VOO has had annualized average returns of 12.63% , compared to 11.96% for VTI. These numbers are adjusted for stock splits and include dividends.

Consider investing in a tax-efficient REIT ETF: Some REIT etfs are more tax-efficient than others. For example, some ETFs have a lower turnover rate, which means they buy and sell assets less frequently, resulting in fewer taxable events.

Positive aspects of ETFs

The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

Stock-picking offers an advantage over exchange-traded funds (ETFs) when there is a wide dispersion of returns from the mean. Exchange-traded funds (ETFs) offer advantages over stocks when the return from stocks in the sector has a narrow dispersion around the mean.